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The large cap myth

In America bigger is better. Houses are getting bigger, trucks are getting bigger, TV's are bigger, smart phones are getting bigger, and Americans are even growing bigger. A neighbor mentioned that they rarely watch TV yet felt compelled to buy a monster sized TV. We have an obsession with large things. Big cities, big roads, big anything and big everything. Our culture says larger is bigger. Bigger portions, bigger trips, bigger weddings, everything is fancier and more extravagant. The American culture attaches significance to largeness. And as such we've somehow come to think that large companies are universally better than small companies, why? It's because they're large and large is good.

The market worships large companies. Large companies are on the news, they're in the papers, everyone wants them on their resume. It doesn't matter how they got there, growth, mergers, fiat, as long as a company they are considered important. For the working public working for a brand name in the mail room is better than being a decision maker someplace no one has heard of. I have a neighbor who lamented to me that there are no more good jobs left in Pittsburgh. He then went on to rattle off a list of large companies that were located here in the 60s and 70s that have since left or been merged away. He made comments like "without these good jobs [the large companies] where will kids work these days?" Maybe kids, which to him is anyone in their 30s and younger, will work for some of the hundreds of tech startups here, or maybe a smaller local company that fills a niche, or maybe they'll be a lucky cube-jockey at a few of the large places we have left.

Investors usually regard management at smaller companies as dopey or out of touch. The theory is why would someone want to work at xzy tiny company when they could have a lavish office, nice perks and status at abc large company? There are a variety of reasons, but often people who work at small places want to have an impact on where they work, not become an office politician.

All large companies have a moat, a moat is a durable competitive advantage. One doesn't need to look hard to identify a large company's moat, it is always the same, it's their size. A large company can be successfully by simply being large. Most large companies are near monopolies, or duopolies or oligopolies for their market. Interested in cable internet for your home? There is always only one provider. What about trash collection? Same thing, a mandated provider. If you're lucky there are two options, usually equally bad. Our township mandates that we use Waste Management (WM), a company where if I were to call them unreliable would be a compliment. Trash pickup schedule? They don't need a schedule, they just expect citizens to leave their waste out for days and when they decide to pick it up they will. Somehow this company is a bastion of capitalism, the type of company that Barrons thinks every investor should own in their portfolio. My Waste Management experience isn't an isolated incident. I have many other experiences as both a client, and as an employee at large companies, too many to count, and most I'd never share online.

What investors don't seem to understand about large companies is what they think is happening on isn't really what's happening at the company. I've seen numerous write-ups that talk about capital allocation or earnings growth or innovation. The only people who care about capital allocation at a large company is the CFO who's massaging the earnings and the CEO who has to remember to mention the term on the quarterly conference calls to assuage investors. Do companies with excellent capital allocation have employees who pad their budgets or "have to spend $500k by the end of the month on *something*" so their budget isn't axed? I've sat in meetings where it has been said "we don't care about ROI" before money was spent on significant initiatives. Failed projects that cost $20m+ and are cancelled with an "oops, guess that was a mistake" are the norm without repercussions. Except to the shareholder capital that's destroyed in the process.

Success at a large organization is determined by political savvy not by the ability to get a job done. If someone is able to build a small empire of loyal troops and obtain high profile projects that person will move up rapidly. They'll move up even if the projects are an outright failure. Political savvy has nothing to do with how well a job is getting done. It's all about alliances and maneuvering and situation handling. Sometimes a threat needs to be neutralized, that threat might be fired, or more likely they'll be stuck on a team with some truly pathetic employees and forced out. Get in the right group and all goes well, the wrong one, and well.... you're bouncing to the competitor across town. I had an old boss who explained that success at a large company was measured by the ability to build a fiefdom. People who could build fiefdoms quickly and grow them moved up, while those who didn't have this ability were cursed to do the actual work while languishing at the bottom of the org chart.

Once one realizes that incentives and motivations at large companies are political much of what they do, or how customers experience the company begins to make sense. One company I knew of was focused on how many times new features were released to clients, not the usefulness of the actual features. More features more often equalled success with management being rewarded with bonuses. Whereas a single impactful feature that took months to implement would be considered a failure. I am also knew of a situation where management was incentivized based on their department's EBITDA. Hiring employees reduced department EBITDA, whereas hiring contractors even at double or triple the cost of employees didn't impact EBITDA because the contractors could be capitalized. I realize that this accounting treatment was dubious at best, but it's how it worked. What was the outcome? The company was very light on employees and very heavy on expensive contractors. Who bore the brunt of this? Shareholders who owned a company that lost money on a GAAP basis, but was wildly profitable if one only looked at Adjusted-EBITDA. This was a company that happily purchased shares at $40-50 a share, but during the crisis when shares traded below $10 decided that instead of repurchasing stock it was more prudent to obtain debt financing with coupons ranging between 15% and 20%. Low and behold, once the stock appreciated management decided to repurchase shares again.

I could go on and on, the stories are crazy. One place was having a bad quarter and told employees to disregard expenses that quarter and spend as much as they wanted. This was because once Wall St saw a loss they wouldn't care about the size of the loss. It was better to shove future expenses in the lost quarter to inflate future earnings. This was a very transparent communication to employees. These aren't one-off things either, but rather the pattern of business. This is just how large companies work.

It isn't to say that employees at large companies are nefarious or evil. There are plenty of great employees who do their best every day and take pride in their job. There are people deep in the bowels of some of these organizations pushing for change and trying to make things better. This is why sometimes our interactions with large companies can be great. Maybe as a customer we cross paths with a department led by a manager who's an agent for change, or someone not satisfied with the status quo.

The problem isn't the people, it's the scale and challenges due to size. At a tiny company waste is noticeable. On a larger scale a small amount of waste across an entire organization becomes a massive amount of waste.

The more one learns the worse it gets. It's almost as if some of these large companies are doing well in spite of themselves. How do they do it? It's all due to their size. Let's go back to the example of my township and Waste Management. Envision the township evaluating waste collection companies for a new contract that grants a monopoly. There is Waste Management, Allied Waste and then Joe's Trash Hauling. Joe's Trash Hauling is a small local company. They are responsive, care about their reputation and are efficient at their job. None of that matters. The township is going to worry about what happens if Joe gets cancer and can't run the company, or if Joe's company can handle the capacity or a million other flimsy reasons that prevent a small company from competing. Everyone has heard of the larger companies, and the larger companies are well equipped to put together a government service proposal. And so citizens are saddled with an inferior provider. This is true for anything at scale.

There is a second aspect that's under appreciated. Large companies love to do business with other large companies. There is repetitional risk for an employee if they decide to use a smaller service provider and then there's an issue. But if it's a large company there is no risk. Large companies presume they will receive premium levels of service from their large company suppliers because they're large. This is the opposite of what happens. I've seen terrible levels of service at large companies because the providing company is large itself and is inefficient (or doesn't care), or they realize that the client either has no alternative, or isn't willing to use a smaller company. The large company becomes a captive client to a monopoly provider. This is one of the reasons why large companies can earn above average rates of return, they have a captive client market and a dominant market position. They can charge above market rates and their clients have no choice but to use them. Zoom out a bit and there is an interconnected network of large companies all bilking each other for services and products. This is not dissimilar to how large companies all have under funded pensions invested in every other large company with an underfunded pension. The network of underfunded pensions all investing in other companies with the same underfunded status is a discussion for another day.

A significant advantage large companies have due to their size is easy access to financing and capital. This comes in handy when a small upstart company begins to threaten their market. The natural large company response is to acquire the threat. Investors often wonder why companies overpay for acquisitions. To anyone who's been in the guts of the machine there is no mystery. They aren't acquiring for technology, expertise or investment return, they're neutralizing a threat. The acquirer has determined that no matter the cost they will eliminate a potential threat. This might be a real or imagined threat, but in the company's mind it is a threat.

I don't want this post to come across with the idea that small companies are perfect, they aren't. But large company actions at a small company level are expressed quickly as poor financial results. Smaller companies don't have the scale to get away with some of the antics that are acceptable at scale. Waste and poor acquisitions impact the bottom line right away. In a large company there might be a rotting dead core that takes a decade to expose itself. The reason spin-offs usually work so well is because when the branch is cut from the trunk all of the waste endemic from being part of a large company is exposed and can be cleaned up quickly. For the management at a spin-off it's almost like shooting ducks in a barrel. Shrink expenses and watch profit grow then earn a giant bonus. It's not like cutting expenses is even hard for them. They just stop doing things like flying a team across the country for a day of useless meetings.

The point of this post isn't to say that large caps are "bad" and small caps are "good", but rather to point out that these are two different types of companies with very different business models and dynamics. Smaller companies are focused on products, growing and gaining marketshare. Large companies are focused on staying where they are and keeping their dominant position. Investors buying large caps should be aware that they're buying pseudo-monopoly players who will spend any and all shareholder money to retain or grow their position. When a company has a dominant market position they will extract as much money from clients as possible until a viable alternative comes along. A discussion about viable alternatives is better left for Clayton Christensen to explain in his excellent book The Innovators Dilemma.

This post might generate a lot of push back from large cap investors. But I'd offer you this. Most investors have never worked at a large cap, most of Wall Street or value investors, or mutual funds have never worked at any of these companies. Their exposure is annual reports and investor conferences. The perspective of Wall Street on large companies is like a person sitting in a timeshare sales meeting. Everything about the resort is great, the views are perfect, and the price is a bargain. Yet for those of us who have worked at the resort we know the true story, the salesmen aren't selling empty desert land, but it's pretty darn close. But the sales team can sell, and as long as they keep selling then all is well.

You might argue that maybe I'm cynical, or maybe I'm jaded, or maybe I'm just pessimistic. I'm not, I'm simply calling a spade a spade and pointing out that the Wizard of Oz is just a man behind a curtain. What I've found so amazing is that anyone who's worked at a large company will agree with me, yet the investor world in general is somehow ignorant to this notion. It's important to know what we're buying, and what motivates people at a company we've invested in. There are ways to make money on both large and small caps, but the dynamics of business due to size are very different. Don't confuse what motivates a small company with what motivates a large company.

11 comments:

Nice piece. Your point about most investors having never worked in any substantial company is quite salient, as is the time share analogy.Perhaps it would suit investors well to do some creative due diligence and benchmark companies in new ways. I have always found Glass Door to be a nifty way to gauge what is really going on, but would love to hear any suggestions.

Glass Door is surprisingly accurate. If there is a single bad review it indicates a potential undercurrent, if there are a lot of bad reviews then it's likely whatever people are complaining about is true.

Talking to employees is another good option. If you talk to enough employees across large companies you'll come to know what baseline culture it. There will be things people complain about at every place, but those are just big companies issues. It's finding outliers beyond that.

I agree with the notion that most investors are way too focused on large caps and moats these days. Most of the moat investors have probably not worked at or started a small company, agreed. This has led to people having the perception that business is way more competitive than it actually is. You can sell an identical item across the street from a competitor for $1 more. Literally a person may have just gone into your shop first (which part of the five forces model explains that?).

Another issue with large caps is that everyone knows that they are awesome. Everyone and their mom knows that Mccormick owns the spice industry. They are very often priced efficiently, or the margin of safety is fairly low, in bull markets.

On the other side of the coin small caps are probably too inefficient for most people to invest in. Most people can't deal with the fact that their stock has gone from 3x p/e to 1x p/e for no particular reason. Honestly most people would be better off investing in large and mid caps because if the value goes up the stock price will often respond as well. Many people would be better off emotionally by investing a portion of their portfolio in special situations or large/mid cap bargains to offset microcap stocks going down 20% for no reason or a microcap doing nothing for 10 years before being bought out at a giant premium etc etc.

This is a very insightful comment. My favorite real life situation that the five forces or economics can't explain is when there are two gas stations across the street from each other and one is charging a few cents more per gallon and both are equally full of cars. The prices are clearly displayed, the people at the higher priced station know they're paying more, and are probably looking at the sign while they pump. Yet for some reason they are happy to do so.

Small caps require an iron constitution. I've had positions halved for no reason. There are two things you can do, the first is panic and sell, the second is suck it up and buy. I've turned some unprofitable positions into very profitable positions by taking advantage of the moment and buying when an undiscriminating seller. But you need to have the awareness/ability to do that. Most investors don't.

When people ask me for portfolio advice I recommend the standard Vanguard Index funds and then ask that they continue to save and never look at their portfolio again, or sparingly. My mom called me recently and wanted to switch up her retirement. It's all index funds and she was disappointed in how they'd done. I noted that they mirrored the market and those areas of the market had done poorly and she understood, but still wanted something that would do better.

I'm partially a convert to the idea of a three fund portfolio. Total stock market, total international market and total bond market. Keep them at 1/3rd each and forget about it.

For enterprising investors there are usually some interesting names at the large end of the small cap space. These are stocks in the $1-2b market cap range.

Hi Nate, I can't agree more. I'm a few years out of university, but have had placements and roles in these some companies of significant size (as is generally recommended for most young people), and I have been a bit frustrated with the situations you have described. Even working for a big 4 accounting firm in consulting there were many practices that made me stop and wonder what exactly I am learning to do here? Is this truly the best practice solution that we are offering or promoting to clients? How are these clients accepting these solutions or turning a blind eye to the fact that they clearly deserve more for what they are paying. I have always consoled myself that this is a necessary step for me to get a better understanding of companies in the hope that it help me as I try to learn how to analyse companiess.So far it has helped very little. I was wondering if you have any advice as to what to take note of during these roles in large companies that will help in investing? Does it help at all?

You need to accept that what you see or what's happening is the reality of the situation and while it might be insanity it's either hard to change, or it's this way because someone wants it. Have you encountered the "paid to sit at an empty desk" yet? This is the worst, a client will want to hold onto you for some period of time but have no work, not even make believe work. You'll be paid for months to sit at an empty desk with zero assignments for eight hours a day. If you haven't had this yet you haven't consulted long enough, give it time...

I'm not sure what can be learned for investing. At points in my past I had similar lofty expectations. That working in xzy industry would allow me to learn it. Instead I'd become an expert in some obscure process used by a tiny fraction of people in that industry.

I've been able to take a lot of things away for investing. The biggest is understanding people and motivations. Why are people making the decisions they're making? What motivates people? Why do departments make these decisions? If you can get a grasp on that it's a universal skill that applies to companies of all sizes. I've looked at small companies doing weird things, put myself in their shoes, thought about motivations and suddenly the whole situation made sense. With that lens you can also work to figure out what a company might do next as well.

Learn what makes projects successful. Also learn what it takes to complete and deliver a project. Why do some very high profile things suddenly die on the vine?

If you really like consulting I'd recommend jumping ship to a smaller boutique firm. Big 4 gets big projects, but they also end up working on some titanics. Projects that are failing that some manager with an unlimited budget thinks if they just tripled the people working on it then it'd finish quicker (never does, fails harder). A boutique firm you'll work on smaller projects but you won't be stuck grinding away on some obscure piece. There's also less travel, although if you enjoy travel it could be good.

One thing I love about consulting is you're exposed to a wide number of companies. And fairly quickly you learn what baseline expectations and feelings are for companies. One of my favorites is at every company I've worked at employees will say "we only hire the best. Our people are what make the difference." And yet the employees are carbon copies with everywhere. Another favorite is "we work extremely hard" and they are working no harder or better than any other competitor. But this perspective can only be gained through broad experience.

Thanks for the advice Nate, I haven’t thought about concentrating on understanding the motivations behind seemingly poor decisions. I’m glad I have not been stuck an engagement/secondment that doesn’t have any substantial deliverable but continues for a significant amount of time for no real reason. However I have worked on a few engagements advising on entrance into new markets that probably did not go through the right process (yet to see whether it was the right thing to do, still probably have a bit of time to play out). It’s interesting how sometimes these engagements are less about providing a reasoned assessment of the strategy itself, but rather more to do with being paid to provide an “independent assessment” in support of the decision that has clearly already been made. Barring any glaringly obvious reasons not to go ahead, these engagements quickly move to a second engagement for implementation rather than truly assessing the pros and cons of the move. And as a consultant, there is very little to gain (and everything to lose) by pointing out the opposing argument/evidence and risking the delay to implementation. I was surprised by this at first, but now I know that this is how decisions are often made at large companies. Despite the vast amount of research, data and data processing capabilities at the hands of major companies, management intuition is often still the main method for making significant strategic decisions, or at least have a significant influence on how the assessment of the opportunity by internal analysts or external consultants are framed. I left consulting a year ago, and initially the level of access to information and detail was extremely exciting for me as it was a great opportunity to see detail that is never available publically. But I have also come to realise as you did that the visibility as a cog in the wheel of a giant company is somewhat limited after a while. It is very hard not to notice that progression beyond a certain point at a big company is often all about politics. The politically and socially savvy operators are often promoted up the chain, and those who become SMEs often sit slightly below middle management and are unable to progress any further because they either lack the connections or have become indispensable and are not allowed to leave their roles. Where such a structure is in place, I have found that the soundness of the decision made really depends on how willing management is to engage the SMEs and how well they have recruited. Senior and middle managers are generally well versed in the daily/weekly/monthly reporting metrics put in front of them to make well informed decisions. But where the decision departs significantly from their daily roles, that is when management could really fail hard as they are susceptible to confirmation bias and often an inability to identify sound analysis from analysis that has been hastily put-together. It’s also unfortunate that sometimes their direct reports or analysts supporting them with the analysis packs have a consulting background. Beautiful pitches do not equate to robust analysis, but often it seems that something pleasing to the eye or delivered more eloquently is more authoritative. It’s really unfortunate that many decision makers in these large companies are susceptible to this as the skillset they have developed in moving up in the ranks do not prepare them for making commercial decisions and strategic initiatives.I just want to say thank you for replying to me. I really enjoy reading your blog, I often have very little to comment about as the topics you cover are as they are outside of my competencies and experiences, but it’s always good to learn new things from your posts on my commutes to work. Cheers :)

I've been in consulting nearly my whole career and have worked with some of the world's largest companies including Walmart, Microsoft, EMC, Cisco Systems, and Sony, as well as a number of mid-caps. In my experience (dangerous to use as a point of reference, i know), you are fundamentally correct in the nature of large caps. Looking at it from the other direction, the type of person who succeeds at a Walmart today is usually a completely different person than the type that would have succeeded in 1970. Or they may be the same person, 40 years later, who likes the pay check but has no motivation except playing out the string. What type of impact does that person have on the orbit of people they touch? Now multiply times a 100 or 1000.

That said, I do believe there is a role for large cap investing, but you do need to have some sort of different knowledge or angle than the common analysis. For example, having worked with Microsoft extensively, I understood that there were a lot of bright people and great ideas that were getting crushed by a highly political environment that a complete buffoon of a CEO had put in place to protect Windows and Office. If they unlocked even a fraction of those ideas it would be highly beneficial. It took a few [a lot] more years than I expected, but you can see the change today with Satya Nadella in charge.

In times of huge market dislocation large caps can also represent better risk / reward. For example, after the crash in 2009 there were a lot of stable companies that weren't going anywhere on fire sale.

So to outperform the alternatives I believe you need to pick your moments or have a better understanding of the specifics than the broader audience. I don't know if that's workable as a complete strategy vs. being an opportunistic type of thing.

Thank you for the good read. As a person who worked for a large Wall St firm for 5+ years supporting management, your description could not have been more on point. The level of horseshit that one encounters while working at these large companies would surprise and disgust an outsider.

I would be remiss if I didn't mention the pang of anxiety I felt when I read:

"This is not dissimilar to how large companies all have under funded pensions invested in every other large company with an underfunded pension. The network of underfunded pensions all investing in other companies with the same underfunded status is a discussion for another day."

It's kind of terrifying because it's *exactly* the type of horseshit that goes on. I look forward to that discussion.